My Company

Aggregation leads to aggravation -- and more taxes sooner, rather than later. The serial annuity rule, also known as aggregation, says that if you own multiple annuities with one company (under one Social Security number and purchased during the same year), withdrawals are taxed as if they were all from one account. And, because interest is distributed first, aggregation generally creates higher taxable amounts in the initial distribution.

This is not a good thing when tax time rolls around. That's why one of my favorite income planning tools is annuity laddering -- the process of using different companies, different products and separate ownership to generate cash flow for your clients. This can lower the taxable portion of each distribution and, therefore, lower taxes. Sometimes, it can even place the client in a lower tax bracket. By laddering, you create the following benefits for your client:

Let me give a simple example. If you sell Mr. Smith a fixed index annuity (FIA) and he takes a withdrawal (either a free withdrawal or via an income-for-life rider), the gain is 100 percent taxable. Specifically, if the initial premium of $100,000 grows to $105,000 and Mr. Smith draws 5 percent ($5,000) via the surrender charge-free withdrawal provision, he pays tax on the full $5,000.

However, it's a different story if Mr. Smith purchases annuities from two different companies, places $50,000 in each, and realizes 5 percent growth over one year to $52,500 in each annuity. In this case, his income situation could look like this:

Product 1: Cash value of $52,500 on a cost basis of $50,000. The client takes a surrender charge-free withdrawal of $5,000 and is taxed on $2,500 as gain, with the rest considered a return of principal.

By simply distributing premium between two different companies, you've helped Mr. Smith cut his current tax obligation significantly.

Creating cash flow with surrender charge-free withdrawals

Taking advantage of the surrender charge-free withdrawal option in each contract is an important rung in your clients' annuities ladder. It can generate cash flow that is minimally taxed during the first year and perpetuates a stream of tax-smart income for the life of the product.

Let's take a scenario in which Mrs. Jones splits $100,000 equally in nonqualified funds between two annuities from different companies. Every year on both contracts, she earns 5 percent, then withdraws 10 percent of the annuity value, surrender charge-free. (Note: If Mrs. Jones takes any withdrawals before age 59½, there may be tax penalties.) Every year, taxes are equal to the amount of growth (gain) on the contract. Mrs. Jones divides her premium as follows:

Product 1, Company 1: $50,000 into a three-year fixed annuity that permits surrender charge-free withdrawals after 30 days. In year one, Mrs. Jones takes advantage of this feature, receiving $5,000 -- and only $20 is taxable. Mrs. Jones will continue to take the 10-percent free withdrawal in Years two and three to provide income. The remaining balance will be distributed after the surrender charge period expires in year four.

Product 2, Company 2: $50,000 into a six-year fixed index annuity (FIA). No income is taken in Year 1. Year 2's value is $52,500. Mrs. Jones can take $5,250 out surrender charge-free, and only $2,500 is taxable. She will continue to take income in years three, five and six. Year 4 income is provided by Product 1, Company 1, whose surrender charge period has lapsed. Here's how Mrs. Jones's income plays out with these two annuities.
(Click here and view the first table)

Mrs. Jones has taxable income of $20,154 on $120,132 in withdrawals. Without this minimal amount of laddering, her reportable income would have been higher, resulting in higher taxes.

Big ladders

As you might guess from these simple examples, a more complex laddering effort -- with more rungs -- can yield greater tax benefits and smooth over the "bumps," or fluctuations, in yearly income. For example, laddering with products coming out of the surrender charge period after years 3, 6, 9 and 12 provides much more manageable and stable cash flows for the client.

Let's add two more products to the previous example, apply the same set of assumptions, and see what such a ladder would look like. Mr. and Mrs. Jones now have $200,000 divided equally among four products from four different companies.

Product 3, Company 3: $50,000 into a nine-year fixed index annuity. The balance will be distributed after the surrender charge period expires in year seven.

Product 4, Company 4: $50,000 into a 12-year fixed index annuity, the balance to be distributed in year 13, after the surrender charge period expires.

Click here and look at the second table to see how the clients' income and taxes would look now:

As you can see, Mr. and Mrs. Jones have created a nice cash flow and a favorable tax climate for themselves. Also, note that the cash flow fluctuates as the surrender charge period expires on each product. It's obvious how more indexed annuities -- assuming they are suitable -- with staggered expiration dates can further benefit your clients. Plus, there's another benefit available to your clients.

The Roth IRA conversion benefit

A big advantage of laddering is that it enables Roth IRA conversions. This conversion capability is an important component of income planning, because it can generate tax-free income for your clients five years from now, while the annuity ladder generates current cash flow and usually creates a favorable tax environment. Although the process is involved, the difference in taxes over a client's lifetime may enable him or her to enjoy a comfortable retirement and leave a legacy. In short, clients can dramatically alter their retirement reality and the family money tree.

In the four-product laddering chart above, the best years for conversions (in red) are Years four, seven, 10 and 13 -- as the withdrawal is higher and its taxable portion is lowest. Remember, the conversion amount must be carefully calculated to ensure that clients aren't thrown into a higher tax bracket.

Your clients can continue partial conversions from their IRAs into the Roth IRA each year. Once the Roth IRA is five years old and the client is 59½, tax-free withdrawals can be made of both principal and gain. (Hint: Use an annuity that enables flexible premiums, as the five-year rule applies to the date the account is established, not the date of the conversion premium.)

Tips and final thoughts

I know laddering sounds challenging -- and it is, although the concept is simple. Do your homework. Not every company will convert an IRA to a Roth IRA without surrender charges. When converting a large IRA to a Roth IRA, I recommend doing it over time. Aim for the annual review to ensure that the client isn't thrown into a higher tax bracket. There is little advantage to be gained by converting to multiple Roth IRAs -- convert only to one account.

Following are a few more considerations and tips:
1. Seek a flexible premium annuity for the Roth IRA.

2. There is little advantage to be gained by converting to multiple Roth IRAs -- convert to only one account.

3. When selecting the laddering products (FIAs and MYGAs), be sure that several allow a yearly surrender charge-free withdrawal. Look for other beneficial features, including income options and various types of riders.

4. Also consider the benefit of an income rider for the Roth IRA.

5. Fund the conversion account from the existing IRA each year by taking the top end of the marginal tax bracket, subtract the taxable income, and convert the difference.

6. After five years, use tax-free cash from the Roth IRA to supplement the client's income.
Finally, call in reinforcements if you need them. Complete a fact-finder and get the tax return. Then, call the home office of your product provider for guidance and product recommendations. Or, contact a marketing organization supporting multiple carriers and offering multiple products. Last but not least, don't forget to remind your clients to consult their CPAs or tax attorneys regarding tax implications.

A properly constructed annuity ladder can mean multiple product sales for you and tax-smart cash flow for your clients.

Note: Legacy and its employees do not give legal or tax advice. The information in this article is based on our general understanding of current tax law and basic features of fixed annuities. Agents should discuss only products and concepts that they are properly trained for and licensed to sell.

*For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.

About the Author

Bruce Beaty, MBA, CLU, ChFC, and CSA, is Regional Vice President of Sales with Legacy Marketing Group®. A nationally recognized speaker and trainer, Bruce has a reputation for developing innovative sales techniques and a history of quickly increasing sales. A speaker and writer who entertains and... More